Concept of Multiplier - Economics

John Maynard Keynes, 1919 and 1945

THE AGGREGATE DEMAND IS COMPOSED OF :

1. CONSUMPTION DEMAND2. INVESTMENT DEMAND

FROM THE CONCEPT OF MULTIPLIER IT IS KNOWN HOW MUCH OR HOW MANY TIMES INCOME INCREASES AS INVESTMENT IS DONE.

AS INVESTMENT INCREASES NATIONAL INCOME INCREASES PROPORTIONATELY MUCH MORE.

HOW MANY TIMES IT INCREASES DEPENDS ON MPC.

HIGHER THE MPC THE NATIONAL INCOME WILL BE GREATER DUE TO INVESTMENT.

RATIO OF CHANGE IN CONSUMPTION TO CHANGE IN INCOME INDICATE THAT PART OF ADDITIONAL INCOME WHICH IS NOT SPENT ON CONSUMPTION.

EG. NATIONAL INCOME = 1200CR FROM 1000CR

CONSUMPTION EXPENDITURE = 900CR FROM 800CR

MPC = 100/200 =.5

THAT PART OF INCOME WHICH IS USED FOR FURTHER PRODUCTION EXPENDITURE MADE FOR THE CREATION OF NEW CAPITAL ASSETS LIKE MACHINE, TOOLS, BUILDING ETC.

TYPES OF INVESTMENT –

AUTONOMOUS INVESTMENT PRIVATE OR PUBLIC INVESTMENT INDUCED INVESTMENT

The Keynesian system: Planned and actual investment

Investment has three components:

• Plant and equipment -- drill presses, factory buildings, etc.

• Residential investment -- new housing construction

• Inventory investment -- Change in Business Inventories

.

The Consumption Function: the key to Keynes

Consumption depends on the level of DISPOSABLE INCOME(disposable personal income = income - taxes = Y - T)

Some consumption is autonomous (= “independent” of DPI):it may depend on other factors such as wealth

or stock values.(even at zero income, Bill Gates would consume something)

The consumption function proposed by Keynes is:

C = C0 + Cy ( Y - T)

C0 = Autonomous consumption

Cy = Marginal propensity to consume

The marginal propensity to consume plays a central role in the Keynesian system. Keep your eye on the MPC in the following slides.

THERE IS AUTONOMOUS INVESTMENT IN ECONOMY MARGINAL PROPENSITY TO CONSUME REMAINS

CONSTANT CONSUMPTION IS THE FUNCTION OF CURRENT

INCOME NO TIME LAG BETWEEN RECIEPT OF INCOME AND ITS

DISPOSAL IN FORM OF CONSUMPTION NET INCREASE IN INVESTMENT SUPPLY OF CONSUMER GOODS IS ALWAYS IN

ECONOMY

IT IS ASSOCIATED WITH CHANGE IN INVESTMENT

SIZE OF MULTIPLIER DEPENDS UPON SIZE OF MPC

MULTIPLIER WORKS IN BOTH FORWARD AND BACKWARD DIRECTION

VALUE OF MULTIPLIER VARIES FROM UNITY TO INFINITY

HIGHER THE MPC –LARGER THE MULTIPLIER SIZE

LARGEST POSSIBLE MPC IS UNITY IF MPC IS ZERO MULTIPLIER IS UNITYK=1/1-MPC THAT IS RECIPROCAL OF

MARGINAL PROPENSITY TO SAVE

TOOL OF ANALYSYING GROWTH, PLANNING, PROJECTING, INVESTMENT REQUIREMENT

TOOL FOR ACHIEVING TARGETED GROWTH RATE, IF MPC IS GIVEN

TOOL FOR ANALYSING THE FLUCTUATIONS IN THE ECONOMY

IMPORTANT TOOL FOR ANALYSING IMPACT OF TAXATION, FOREIGN TRADE ON THE ECONOMY

MULTIPLIER DEPENDS ON A LARGE NUMBER OF FACTORS ALONG WITH MPC

EFFICIENCY OF PRODUCTION REGULAR INVESTMENT MULTIPLIER PERIOD FULL EMPLOYMENT CEILING ASSUMPTION THAT GOODS AND SERVICES

ARE AVAILABLE IN ADEQUATE SUPPLY GOODS AND SERVICES CANNOT BE

PRODUCED IN EXCESS OF THEIR FULL EMPLOYMENT LEVEL

USEFUL TO ANALYZE PUBLIC INVESTMENT

REMOVES DEPRESSION THROUGH GOVERNMENT INVESTMENT

ACHIEVING FULL EMPLOYMENT MARGINAL EFFICIENCY OF CAPITAL

EMPLOYMENT RISES PRIVATE INVESTMENT ENCOURAGED

STATIC MULTIPLIER COMPARATIVE STATIC MULTIPLIER DYNAMIC MULTIPLIER

PROPOUNDED BY KAHN GOVERNMENT UNDERTAKES PUBLIC

WORKS,THIS LEADS TO INITIAL AND PRIMARY EMPLOYMENT.

THIS RESULTS IN INCREASE IN DEMAND FOR CONSUMPTION GOODS WHICH IN TURN PROVIDES MORE EMPLOYMENT.

Does not applies to underdeveloped countries like India.

REASONS:1.DEMANDS CAN BE MET EASILY IN

DEVELOPED COUNTRIES.2.SUPPLY OF RAW MATERIALS IS ELASTIC IN

DEVELOPED COUNTRIES.3.THERE IS NO INVOLUNTARY EMPLOYMENT.

PAYING OF DEBTS IDLE CASH BALANCES. IMPORTS. PURCHASE OF EXISTING SECURITIES. PRICE INFLATION

Keynesian equilbrium: Solution procedure

Start with the equation in general form:

Y = C0 + Cy ( Y - T) + Ip + G + NX

Substitute in the given numbers:

Y = 300 + 0.8 ( Y - 1000) + 1500 + 1200 + 500

Collect all the constant terms:

Y = 3500 + 0.8Y - 800

Y = 2700 + 0.8Y

Subtract 0.8 Y from both sides of the equation:

0.2 Y = 2700

Finally, multiply both sides by 1 / 0.2 = 5

Y = 5 (2700) = 13, 500

The Multiplier

Rerun the previous exercise, raising planned investment by 500.

Y = 300 + 0.8 ( Y - 1000) + 2000 + 1200 + 500

Collect all the constant terms:

Y = 4000 + 0.8Y - 800

Y = 3200 + 0.8Y

Subtract 0.8 Y from both sides of the equation:

0.2 Y = 3200

Finally, multiply both sides by 1 / 0.2 = 5

Y = 5 (3200) = 16, 000

GDP is UP BY 2,500, NOT up by only 500.

Investment spending has a MULTIPLIER EFFECT of 5